US corporate tax reform (iii)

For years ago I wrote in detail about today’s topic, which is deferred taxes.

The basics:

–deferred taxes are an accounting device that reconciles the cheery face a company typically present to shareholders with the more down-at-the-heels look it gives the IRS, while accurately reporting to both parties the cash taxes paid

–look at the cash flow statement, which, as the name implies, shows the cash moving in and out of the company or in the income tax footnote to get the particulars for a firm you may be interested in.

accounting for a loss

The issue I’m concerned about in this post is what happens when a company makes a loss.

reporting to the IRS

The income statement for the IRS looks like this:

pre-tax income (loss) ($100)

income tax due 0

after-tax income (loss) ($100).

reporting to shareholders

Financial accounting books, in contrast, look like this:

pre-tax income (loss) ($100)

deferred tax, at 35% $35

after-tax income (loss) ($65).

what’s going on

The financial accounting idea, other than to cosmetically soften the blow of a loss, is that at some future date the company in question will again be making money. If so, it will be able to use the loss being incurred now to offset otherwise taxable future income. Financial accounting rules allow the company to take the future benefit today.

It’s important to note, however, that the deferred tax is an estimate of future tax relief, based on today’s tax rates.

why does this matter?

Profits add to shareholders’ equity; losses subtract from it. Under the GAAP accounting used for reports to stockholders, a loss-making company only has to write down its shareholders’ equity (aka net worth, book value) by about two-thirds of the actual loss. To the casual observer, and to the value investor using computer screening, it looks stronger than it probably should.

Financial stocks typically trade on price/book. This is also the sector that took devastatingly large losses during the financial crisis (that they caused, I might add).

Suppose the corporate tax rate is reduced to 15%.

This diminishes the value of any tax loss carryforwards a firm may have. It also may require a substantial writedown of book value, making that figure more accurate. But the writedown may also underline that the stock isn’t as cheap as it appears.